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A change of tune at the Fed?

18 June 2021

Jeremy Sterngold, Head of Fixed Income

Investors nervously anticipated this week’s US Federal Reserve (Fed) meeting. Given the array of upbeat data released since the central bank last shared its projections for employment, growth and interest rates, investors were keen to see how the Fed expects to respond to an economy that is recovering quickly from the pandemic. In particular, investors were hoping to get a sense of when the Fed is contemplating tapering its asset purchases, as well as the outlook for interest rates.

Rate hike in 2023

The so-called “Dot” plot showed that the majority of Fed members now expect to hike interest rates in 2023, with median projections showing two 25 basis points rate increases that year. Relative to no increases anticipated in March, this change in position was a surprise for markets. As a reminder, the Fed tends to first taper asset purchases at least several months before hiking interest rates. Yesterday, Chair Powell indicated that the Fed would provide advance notice before tapering purchases. This implies that tapering should occur during 2022 and that we could see the Fed announcing their intention to taper later this year. Chair Powell continued to highlight that it is highly dependent on economic progress towards the Fed’s goals.

Hawkish or reactive?

We do not necessarily see this as a major hawkish shift by the Fed, but a response to the economic data released since they last updated the market with its projections. Back in March, the Fed met just after Congress passed President Biden’s stimulus plans, that included further stimulus cheques.

The subsequent retail sales data showed that consumers had a strong propensity to spend these proceeds, which in turn accelerated the economic recovery. Pent up demand, combined with supply-side constrains have lifted inflation, as highlighted through sales of second-hand cars and domestic lodging costs. This broadly confirms the view that inflationary pressures will be transitory over the medium-term, albeit with inflation running above target in the near term.

The labour market is being monitored particularly closely. When questioned during the post-meeting press conference, Powell mentioned the elevated levels of job openings, indicating that they do not believe they face a “supply” of jobs problem. The easy and rapid job gains have passed us; most employees have now returned to their employers, especially across the hospitality sector. Hiring new people is proving more time intensive, and issues such as childcare or other carer responsibilities are potentially delaying people re-entering the labour market. The generous unemployment benefits, which expire in September, may also disincentivise people to get jobs. Based on these potential factors, it is here where the Fed needs to see more progress, before communicating its intention to taper purchases. Hence, future job reports may have an outsized impact on rate expectations over the coming quarters.

Market response

Bond and equity markets weakened following the Fed’s announcement. Bond yields, in what is known as the belly of the curve (5-year and 10-year), rose sharply, with 5-year Treasuries closing 11 basis points higher, ending up at 90 basis points (or 0.9%). Ten-year notes rose 8 basis points from 1.49% to 1.57%. However, 30-year Treasuries were broadly unchanged. For some time, we have recommended longer-dated Treasuries for those looking to balance risk in portfolios, in anticipation that as short-term rates normalise the yield curve may flatten.

Conclusion

In 2017, as the Fed looked to withdraw the stimulus put in place during the financial crisis, the then Chair of the Fed, Janet Yellen, said that normalisation would be like “watching paint dry”. This week, the Fed has given the first indication that they may look to withdraw some of the pandemic stimulus but will want to do so without upsetting the path to recovery. We expect that the Fed will continue to err on the side of caution and only gradually shift their wording to prepare markets for a slow, gradual withdrawal of the support put in place during the pandemic.

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